THE LOWDOWN ON LLCs

Combining the flexibility and tax advantages of partnerships with the limited-liability features of corporations, Limited Liability Companies (LLCs) are a hybrid that some experts predict may become the form of choice for most new businesses.

Until recently, if you owned a business, you had to decide whether to operate as a sole proprietorship, general partnership, limited partnership, corporation, or one of several other more esoteric business forms. An intelligent selection required an extensive and time-consuming comparison of the various tax, liability, and operational features of each. The decision for business owners was complicated by the fact that each of these forms had significant advantages and disadvantages:

• Proprietorships

These are easy to set up, and many businesses start in this format. Income is taxed only at the proprietor’s level. However, both a proprietor and a partner are personally liable for the debts and obligations (including taxes) of the business.

• Limited Partnership

In a limited partnership, only the general partner carries the liability for the partnership’s obligations. Limited partners are protected and are not personally liable for the debts and obligations of the partnership.

There are restrictions, however, on the ability of limited partners to actively participate in the management of the business. Failure to abide by these restrictions could result in their loss of limited liability protection.

• The General Partnership

General partnerships offer considerable flexibility in allocating economic benefits among partners. Moreover, the income of a partner is taxed only once at the partner level. On the down side, those in a partnership are personally liable for all the obligations of the business.

• Traditional Corporations

The C Corporation format offers tremendous management and financing flexibility, but its income is taxed twice: once at the corporate level, and again on the shareholder level.

Officers (who are normally substantial shareholders) are also liable for certain corporate obligations (withholding and sales taxes) and sometimes for acts of the corporation.

• The S Corporation

Finally, S corporations are generally taxed like partnerships (and so avoid a second level of tax) and provide their shareholders with limited liability protection as well. On the other hand, S Corporations pose significant restrictions on ownership eligibility. For example, they allow no more than 75 shareholders and cannot be owned by corporations, nonresident aliens, qualified retirement plans, and most trusts.

THE NEW BUSINESS FORM EMERGES

In 1977, Wyoming took a gigantic step forward, enacting a statute that permitted the establishment of a brand-new form of business structure: the Limited Liability Company (LLC). LLCs combine the advantages of both the corporate and partnership forms of business.

The result: a revolutionary hybrid that many experts predict will become the form of choice for most new businesses.

The LLC went largely unnoticed in the business and legal community until 1988. In that year, the IRS issued Revenue Ruling 88-76 that concluded that a Wyoming LLC could be classified as a partnership for federal income tax purposes, and so avoid the “entity level” or double tax imposed on regular corporations, while its members were not personally liable for the debts of the company.

This ruling began a movement throughout the country’s statehouses that grew to virtual tidal-wave proportions, with all states eventually adopting the required enabling legislation.

WHAT IS AN LLC?

An LLC is a unique business form that combines the flexibility and tax advantages of partnerships with the limited-liability features of corporations. At the same time, it eliminates all restrictions on ownership, as well as restraints on active participation by its owners, and can be tailored to maximize a business’ operational and management flexibility.

Like other business forms, LLCs are created in accordance with procedures established by state law. While the details of each state’s laws may vary, the basics remain generally the same. The owners of LLCs are protected from the obligations of the business in the same way that shareholders are protected from liability for the obligations of a corporation.

In most other respects, LLCs resemble partnerships and are taxed as partnerships (to avoid the “entity level” tax imposed on corporations) if structured so that the IRS is satisfied that they have no more than two of the following four corporate characteristics: limited liability, centralized management, free transferability or ownership interests, and continuity of life.

Since LLCs generally have limited liability, the other three factors must be carefully considered when establishing a new LLC enterprise:

1. Centralized management exists if the authority to manage the business rests in the hands of one or more - but less than all - members, or in the hands of one or more managers elected by the members.

2. Free transferability means an owner can transfer his or her ownership interest in the business, including the right to participate in the management of the business, without obtaining the consent of the other members.

3. Finally, continuity of life exists for the business if the death, insanity, bankruptcy, retirement, resignation, or expulsion of a member does not dissolve the business.

BULLETPROOF AND FLEXIBLE

State legislatures have addressed the importance of insuring that LLCs formed under their acts would possess two or fewer corporate characteristics in two different ways. Some legislatures have enacted “bulletproof” LLC acts. Other states have enacted “flexible” LLC acts.

BULLETPROOF LLC ACTS: automatically confer partnership tax treatment on an LLC formed in compliance with that state’s provisions. These acts preclude an LLC from ever having a majority (three or four) of the corporate characteristics identified above.

FLEXIBLE LLC ACTS: adopted by other states, permit business owners to fashion the use of corporate characteristics in structuring their LLC. Although flexibility has obvious advantages, extra care must be exercised to ensure that an LLC does not inadvertently have a majority of the corporate characteristics. Failure to do so will result in the business being taxed as a corporation rather than as a partnership.

OWNERSHIP OF AN LLC

LLCs are owned by members. An ownership interest in an LLC confers on a member the right to a designated share of the profits and losses of an LLC, the right to vote, and the right to receive distributions from the LLC. Unlike S corporations (that cannot have more than 35 shareholders), there is no limit on the number of members an LLC may have.

On the other hand, most authorities agree that a one-member LLC cannot be considered a partnership for federal income tax purposes (since a partnership refers to a business with at least two co-owners), and so may be taxed as a corporation. Be safe. If possible, have at least two members in your LLC.

FORMING YOUR LLC

An LLC is formed by filing the articles of organization with the Secretary or designated official of the state in which the LLC is established. Typical provisions in the articles include the name and address of the LLC, an agent for service of process, and the latest date the LLC shall be dissolved.

Although not required by law, members of LLCs should also enter into operating agreements with one another. These are documents created to establish internal governance rules for the operation of the business. Similar to a shareholder agreement, the operating agreement may, among other things, control how profits, losses, distributions, and management powers are distributed among the members. If an operating agreement is not prepared, the rules of operation set forth in the LLCs home state will apply by default.

LLCs can be managed by their members, or the management responsibility can be delegated. A manager may be an individual, a partnership, a corporation, or even another LLC. Managers may also appoint officers (such as a president, vice president, treasurer, etc.) to help run the LLC. Unless limited by an LLCs articles or organization, managers and officers are able to bind the LLC to contractual obligations.

Although LLCs work beautifully for most common types of businesses, they also work well in more-complex structures. Joint ventures, investment groups, international partnerships, high-technology ventures, real-estate developers, and professionals are some of the businesses that may profit from use of an LLC. Why? Because LLCs offer limited-liability protection, pass-through tax treatment, and flexibility in structuring managerial responsibility and in allocating priority cash flows and tax benefits. Other business forms generally cannot ordinarily provide all of these benefits to their owners (who often have differing interest).

CONVERTING YOUR BUSINESS

OK! You have the message. LLCs have distinct advantages. You like all their features. The only thing you do not like is the fact that your existing business is not an LLC.

Relax. It may be possible for you to convert your business to an LLC. General and limited partnerships can often be converted tax-free. Corporations can also be converted, although the process usually first requires liquidation of the corporation followed by a contribution of the assets to an LLC. This route makes it more likely for an owner to pay tax on a conversion of a corporation to an LLC, but there may be opportunities to minimize or avoid such taxes. Consult your professional advisors.

FACTS TO CONSIDER

Notwithstanding their significant advantages over other business forms, LLCs do have certain limitations:

• Lack of legal precedents

The LLC is a new form of business, so there is little legal precedent available to help owners predict how the law will be applied (although established legal principles for corporations and partnerships will quickly be extended to apply to LLCs).

• Lack of uniform laws or treatment

There is currently no federal or uniform LLC act, so that each state LLC act is unique. As a result, there is some uncertainty about how LLCs properly formed in one state will be treated in another state with a different LLC act or in one that has not yet authorized the use of LLCs. Most states, however, now provide that an LLC established in another state could qualify to do business in their state, and so will be recognized as an LLC.

• Lack of uniform tax treatment of LLCs

A few states impose income or franchise taxes on LLCs while not imposing a like tax on S corporations. However, unless you engage in interstate commerce, this will not have great effect.

SUMMARY

If you compare the LLC benefits and drawbacks to other business forms, you may find that you too can profit by forming your own Limited Liability Company, or converting an existing enterprise to an LLC.

Source: Tax Facts 2003, National Underwriter Company